One questions many “for sale by owner” sellers ask is “how can I determine if a possible buyer can provide to buy my house?” In the real estate industry this is referred to as “pre-qualifying” a buyer. You might think this is a complicate course of action but in reality it is truly quite simple and only involves a little math. Before we get to the math there are a few terms you should understand. The first is PITI which is nothing more than an abbreviation for “principal, interest, taxes and insurance. This figure represents the MONTHLY cost of the mortgage payment of principal and interest plus the monthly cost of character taxes and homeowners insurance. The second term is “RATIO”. The ratio is a number that most edges use as an indicator of how much of a buyers monthly GROSS income they could provide to use on PITI. nevertheless with me? Most edges use a ratio of 28% without considering any other debts (credit cards, car payments etc.). This ratio is sometimes referred to as the “front end ratio”. When you take into consideration other monthly debt, a ratio of 36-40% is considered permissible. This is referred to as the “back end ratio”.
Now for the formulas:
The front-end ratio is calculated simply by dividing PITI by the gross monthly income. Back end ratio is calculated by dividing PITI+DEBT by the gross monthly income.
Let see the formula in action:
Fred wants to buy your house. Fred earns $50,000.00 per year. We need to know Fred’s gross MONTHLY income so we divide $50,000.00 by 12 and we get $4,166.66. If we know that Fred can safely provide 28% of this figure we multiply $4,166.66 X .28 to get $1,166.66. That’s it! Now we know how much Fred can provide to pay per month for PITI.
At this point we have half of the information we need to determine whether or not Fred can buy our house. Next we need to know just how much the PITI payment is going to be for our house.
We need four pieces of information to determine PITI:
1) Sales Price (Our example is 100,000.00)
From the sales price we subtract the down payment to determine how much Fred needs to borrow. This consequence brings us to another term you might run across. Loan to Value Ratio or LTV. Eg: Sale price $100,000 and down payment of 5% = LTV ration of 95%. Said another way, the loan is 95% of the value of the character.
2) Mortgage amount (principal + interest).
The mortgage amount is generally the sales price less the down payment. There are three factors in calculating how much the PI& interest) portion of the payment will be. You need to know 1) loan amount; 2) interest rate; 3) Term of the loan in years. With these three figures you can find a mortgage payment calculator just about anywhere on the internet to calculate the mortgage payment, but remember you nevertheless need to add in the monthly portion of annual character taxes and the monthly portion of danger insurance (character insurance). For our example, with 5% down Fred would need to borrow $95,000.00. We will use an interest rate of 6% and a term of 30 years.
3) Annual taxes (Our example is $2,400.00)/12=$200.00 per month
Divide the annual taxes by 12 to come up with the monthly portion of the character taxes.
4) Annual danger insurance (Our example is $600.00)/12=$50.00 per month
Divide the annual danger insurance by 12 to come up with the monthly portion of the character insurance.
Now, let’s put it all together. A mortgage of $95,000 at 6% for 30 years would produce a monthly PI
Putting it all together
From our calculations above we know that our buyer Fred can provide PITI up to $1,166.66 per month. We know that the PITI needed to buy our house is $819.57. With this information we now know that Fred DOES qualify to buy our house!
Of course, there are other requirements to qualify for a loan including a good credit rating and a job with at the minimum two years consecutive employment. More about that is our next issue.